4) Understanding and valuing options

Question 1

long call option

Answer 1

right to buy asset

Question 2

short call option

Answer 2

obligation to sell asset

Question 3

long put option

Answer 3

right to sell asset

Question 4

short put option

Answer 4

obligation to buy asset

Question 5

american option

Answer 5

exercised at ANY TIME prior to and including expiration date (more flexible, usually higher value)

Question 6

european option

Answer 6

exercised only on the expiration date

Question 7

how are position diagrams different to profit diagrams?

Answer 7

only show payoffs at option exercise price, they don’t account for the initial cost of buying the option or the initial proceeds from selling it

Question 8

protective put

Answer 8

A protective put position is created by buying (or owning) stock and buying put options on a share-for-share basis.

involves holding a long position in the underlying asset (e.g., stock) and purchasing a put option with a strike price equal or close to the current price of the underlying asset.

Question 9

aim of protective put

Answer 9

limit potential losses that may result from an unexpected price drop of the underlying asset.

Question 10

to go long on a call option

Answer 10

investor hopes to benefit from an upward price movement in an asset. The call gives the holder the option to buy the underlying asset at a certain price.

Question 11

go long on a put option

Answer 11

an investor who expects an asset’s price to fall—will be long on a put option—and maintain the right to sell the asset at a certain price.

Question 12

a short position

Answer 12

is created when a trader sells a security first with the intention of repurchasing it or covering it later at a lower price.

Question 13

what is the benefit of a protective put

Answer 13

if you buy a stock and the price starts to drop, you can exercise put option to sell the stock at the higher price, even though present price is far lower.

Question 14

Straddle (unlimited profit, limited risk options trading strategies that are used when the options trader thinks that the underlying securities will experience significant volatility in the near term)

Answer 14

simultaneously buying of a put and a call of the same underlying stock, striking price and expiration date.

Question 15

when is a straddle strategy popular

Answer 15

when the price of the security rises or falls from the strike price by an amount more than the total cost of the premium paid. Profit potential is virtually unlimited, so long as the price of the underlying security moves very sharply.

Question 16

Determinants of the value of a call option

Answer 16

1. Increases with the ratio of the asset price to the exercise price
2. Increases with interest rate and the time to maturity
3. Increases with the variance per period of the stock return multiplied by the number of periods to maturity

Question 17

Determinants of the value of a call option:

2. Increases with interest rate and the time to maturity

Answer 17

a. When you own an option, you know that it will be exchanges for a stock at some point. Hence its equivalent to buying the stock but financing part of the purchase via a loan – the amount implicitly borrowed is the present value of the exercise price.
b. Hence higher interest rates mean that the present value of the exercise price falls.
c. Furthermore, the exercise price is paid at a later date. Hence a longer time to expiration increases the time premium.

Question 18

Determinants of the value of a call option:

3.Increases with the variance per period of the stock return multiplied by the number of periods to maturity

Answer 18

a. Higher volatility of stock prices will allow more chances for the option to be exercised – more upwards potential.
b. You would like to hold a high volatility stock for a long time.
c. Hence an option written on a risky (high-variance) asset is worth more than an option on safe asset.

Question 19

Determinants of the value of a put option:

Answer 19

o Cash spent purchasing put options is essentially interest payable, so holder of a put option has a cash disadvantage that depends on the level of the risk-free rate.

Question 20

price of underlying asset increases

Answer 20

call option increases

put option decreases

Question 21

price of underlying asset decreases

Answer 21

call option decreases

put option increases

Question 22

strike price increases

Answer 22

call option decreases

put option increases

Question 23

strike price decreases

Answer 23

call option increases

put option decreases

Question 24

volatility of the asset increases

Answer 24

call option increases

put option decreases

Question 25

volatility of the asset decreases

Answer 25

call option decreases

put option increases

Question 26

what are the 5 variables that the value of an option depends on

Answer 26

1. Higher Price of the underlying asset -> More valuable an option to buy it
2. Lower exercise price -> More valuable the option
3. Longer maturity date, the more valuable an option – especially when interest rates are high
4. If stock price is below EP at maturity the call is valueless regardless of whether the price is $1 below or $100 below. But for every dollar that the stock P rises above EP, option holder gets an extra $1. Thus value of call option increases with the volatility of the stock P.
5. A long-term option is more valuable than a short term option bc a distant maturity delays the point at which holder needs to pay the EP and increases the chance of a large jump in the stock P before the option matures.

Question 27

why can’t options be valued using the discount rate?

Answer 27

it’s impossible to find the opportunity cost of capital as the risk of an option changes every time the stock price moves.

Question 28

• The higher the stock price is relative to the EP the

Answer 28

safer the call option, although the option is always risker than the stock. The option’s risk changes every time the stock price changes.

Question 29

are options riskier than stocks

Answer 29

yes

Question 30

how to create downside protection for put options

Answer 30

Buying the share + buying a put option
–> if stock price rises above EP, option is valueless but you still get the gains from the investment in the stock

–> if stock price falls below EP, can exercise option and sell at EP

Question 31

what’s the cost of insuring for downside protection for puts?

Answer 31

the amount you pay for the option

Question 32

downside protection for call options

Answer 32

buying the share + buying a call option
–> is stock price rises above EP, can exercise call option and buy at EP

–> if stock price falls below EP, call option is valueless but you still get gains from investment

Question 33

Fundamental relationship for European call options:

Answer 33

Put call parity

Value of call + PV of EP = value of put + share price

Question 34

When does the put-call parity apply?

Answer 34

This relationship only applies if the option is held to maturity and hence does not hold for American options.

Question 35

o if investors indifferent to risk:

Answer 35

expected return = risk-free interest rate

Question 36

sellselling a straddle

Answer 36

investor aims to earn profit from low volatility in the market (graph is flipped)- gains when price isn’t moving much in either direction